Opinion: Industry-momentum portfolios also have good long-term returns

Industry-momentum portfolios — which jump into and out of various sector funds in an attempt to profit from those performing best at any given time — had a very good 2013.

In fact, nine of the 10 most profitable mutual-fund portfolios last year — out of the more than 250 monitored by the Hulbert Financial Digest — pursued such a strategy, also referred to as “industry rotation.” These nine produced an average gain of 41%, in contrast to a 32% return for the S&P 500, assuming dividends were reinvested.

Unlike many other strategies that lead the performance rankings in a given year, only to lose much or all of it in the next, many industry-momentum portfolios sport impressive long-term returns as well. Six of the nine that ranked highly in 2013 have been around for at least a decade, and each of them outperformed the S&P 500 over this longer period as well.

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Of course, not all industry-momentum strategies beat the market. But enough of them do over the long term to warrant a closer look.

Though momentum strategies are quite popular on Wall Street, many investors who follow them focus on individual stocks as opposed to industries. They constantly reshuffle their portfolios to own those stocks that recently have performed the best and shun those that have performed the worst — an approach that can lead to a large number of transactions and associated costs.

This focus on individual stocks appears to be largely unnecessary, according to Tobias Moskowitz, a finance professor at the University of Chicago. He says investors can capture much, if not most, of the “momentum effect” among larger-cap stocks by focusing on industries rather than individual stocks.

In other words, the bulk of the outperformance that typically comes from buying high-momentum stocks comes from their being in industries that are themselves beating the market.

The investment implication of this research doesn’t mean you should invest in just the one or two top-performing industry funds, says James Lowell, editor of an industry-momentum advisory service called Fidelity Sector Investor. Such an approach would be riskier than most investors would be willing tolerate, since it involves putting all your eggs in just one or two baskets, he says.

Lowell’s top industry-momentum strategy, which he calls the “Technology Plus” portfolio, is in first place for 10-year returns among mutual-fund strategies tracked by the Hulbert Financial Digest, with a 14% annualized return in contrast to the S&P 500’s 7.5%. “Diversification is a core principle of any great momentum model,” he says.

Each of the top industry-momentum strategists constructs his model portfolio to be more diversified than would be the case if he owned only the industry-specific funds with the best recent performance. On average they recommend that their model portfolios contain six separate funds. And they favor funds that tend to move independently of each other.

That means, for example, that they wouldn’t recommend owning both an energy fund and an energy-services fund, even if both were at the top of the rankings for recent performance.

Another way to reduce the risks otherwise associated with a pure momentum strategy is to allocate to it only a portion of the funds you otherwise have invested in stocks. Lowell, for example, recommends you allocate no more than 10% of your stock funds to his industry-momentum strategy.

Most of the top-performing industry-momentum strategists also favor actively managed industry funds over exchange-traded funds that track an industry benchmark. This isn’t because all active industry funds beat their benchmarks. Instead, according to Lowell, it is because a good manager has a better chance of beating his benchmark when his industry itself is hot.

In other words, a momentum strategy holds out the prospect of not only identifying industries that will lead the market over the next couple of months, but also those managers that will do the best job of exploiting that leadership.

The strategists’ preference for actively managed industry funds most often leads them to recommending Fidelity’s Select funds, each of which focuses on an individual sector. All but one of the nine industry-momentum strategies that performed the best in 2013 invest either exclusively or primarily in these Fidelity funds.

Lowell says this preference derives in large part because Fidelity offers the biggest array of industry-specific funds with track records that extend back many years. They currently offer 40 such funds. Nevertheless, he adds, an investor doesn’t have to limit himself to just one kind of fund or another, and he sometimes recommends a combination of both ETFs and actively managed industry funds.

The industries that currently are favored by the greatest number of the top-performing industry-momentum strategists include biotech, computer software, health care and retail.

The four actively managed funds most often recommended by these strategists to capture the expected momentum in these industries are Fidelity Select Biotechnology
FBIOX, +1.16%
, which has annual fees of 0.81%, or $81 per $10,000 invested; Fidelity Select Health Care
FSPHX, +1.00%
, with fees of 0.79%; Fidelity Select Retailing
FSRPX, +0.51%
, with fees of 0.86%; and Fidelity Select Software & Computer Services
FSCSX, -0.12%
, with fees of 0.82%.

The ETFs in these four industries that currently are favored by the greatest number of these strategists include iShares Nasdaq Biotech ETF
IBB, +0.98%
, which charges fees of 0.48%; First Trust Health Care AlphaDEX
FXH, +0.79%
, with fees of 0.70%; PowerShares Dynamic Retail
PMR, +0.28%
, with fees of 0.63%; and SPDR S&P Software & Services
XSW, +0.30%
, with fees of 0.35%.

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